Shares of mortgage REITs such as Annaly Capital
A lot of news and speculation about mortgage REITs has hit the wires recently. In August, Federal Reserve Chairman Ben Bernanke signaled that he would keep interest rates low until 2013, a welcome move for American Capital Agency
But three other concerns have weighed on shares: declining interest rates, a change in SEC regulation, and Operation Twist.
Declining interest rates could hurt the mortgage REITs. A flattening yield curve reduces the interest-rate spread on which the companies make money. As these companies have to reinvest the proceeds of higher-yielding securities into lower yields, it could push down the spread they can realize, ultimately hurting dividends. But to offset the decline, mortgage REITs could take on modestly more leverage to maintain those eye-bulging yields. And, of course, the companies are still borrowing at near-zero rates, a fact that won’t change until at least 2013, if we believe the Fed.
Speculation has been rife that the SEC might decide to limit how mortgage REITs function. Per The Wall Street Journal: "The U.S. regulator sought comment on whether mortgage REITs should lose their tax exemption or their ability to use leverage. The plan seems to be to force them to choose one of two options: become a regular corporation -- and get taxed like one -- but keep the leverage or lose the leverage and keep the tax exemption."
But at least one investment bank has come out to say that any change would probably not materially alter the environment for mortgage REITs.
Also of concern is the so-called Operation Twist, in which the Fed swaps longer-dated bonds for short-term paper to reduce long rates, narrowing the spread. Such a move hurts mortgage REITs since they make more money with a larger spread. But the Fed has proposed only a modest investment in longer-term notes, one that is estimated to move down 10-year rates by perhaps 13 basis points, according to Jim Hamilton, a professor of economics at the University of California at San Diego. With short-term rates near zero, that would do little to affect profitability at the mortgage REITs.
Over the last quarter, mortgage REITs with longer-dated agency-backed investments, such as Annaly, CYS, and Armour have outperformed the S&P as well as mortgage REITs focused on shorter-dated agency investments, including Anworth Mortgage
Foolish bottom line
Although there's a fair amount of speculation about the future for mortgage REITs, the case for the market's hottest dividend payers still looks decent. So I think the money will keep flowing to these dividend machines.